The exploration, development, and exploitation of natural resources in the petroleum and mining industries are high risk, capital-intensive ventures. The companies engaging in the exploration, development, and exploitation of natural resources frequently require financing. Over the life cycle of a petroleum or mining company, financing may be required for loans, acquisitions, or mergers with other companies. Although there are risks associated with any financial transaction, there are additional risks specific to the exploitation of natural resources. Risks include geological, engineering, and management risks, in addition to risks associated with the size of the package of assets involved in the transaction.
The size of the package of assets exemplifies the risks associated with a package of petroleum wells. Typically, 20% of the wells have 80% of the value reflecting an underlying exponential distribution of value. The result is that a small number of wells in a package of assets may create a high variance in possible returns, while a large number of wells in a package of assets will reduce variance in possible returns.
Traditional financing structures may not mitigate the high investment risk related to the exploration, development, and exploitation of natural resources. Investment risk is particularly high for wildcat exploration in unproven fields, so that historically financing has not been possible. Less risky are the small packages of assets, but high volatility of returns with small packages often precludes financing or makes financing very expensive. Large low risk packages of assets can be financed, but the loan size may be only a small fraction of the assets value. The combination of high risk and low collateral value to investors in financing natural resource exploration results in prohibitively expensive financing options, and that is the case if financing is available at all.
Attempts to reduce financing transaction risk begin with contractual relationships between the company and the financial community. For a long time banks have used contractual relationships to control risk, by limiting their exposure and aggregating assets to collateralize a loan. By federal statute, banks are limited by charter from lending 100% on real estate or petroleum transactions, regardless of how well the loan is collateralized.
Each market must first determine a value of a package of assets. There are different procedures for determining value, and different markets each require a specific procedure. Each valuation procedure is a mathematical representation of value. These known asset valuation procedures lend themselves to designing a business process that mitigates some of the problems in financing risky ventures.
Examples of mathematical representations of value include, but are not limited to: present worth, cash flow, risk adjusted value, and expected value. Cash flow (“CF”) is the annual revenue generated by an investment. CF is commonly used in financial markets to evaluate the annual return on investment of bonds and perpetuities. Present worth (“PW”) is the sum of the discounted cash flow from an asset. The discount cash flow includes the cost of money and may include an additional interest rate designated as the “risk premium.” PW is widely used in valuing low to medium risk assets.
Risk Adjusted Value (“RAV”) provides a valuation metric for decision purposes in high risk investments that is equivalent to PW used for low risk investments. The basis for the RAV analysis is exponential utility theory that discounts for risk using a buyer's risk preferences. RAV was developed for managing oil and gas exploration and investment portfolios beginning in about 1977 and is widely used today. In addition to petroleum and mining, RAV is used by insurance companies to evaluate high-risk investments and high-risk investment portfolios. RAV is commonly used in exploration markets in the same way that PW is used in production markets.
Expected Value (“EV”) is used in valuing wildcat Overriding Royalty Interest (“ORRI”). Mineral interests are divided into operating and non-operating interests. The operating or working interest pays all investment and operating costs and is subject to the outstanding non-operating royalty and ORRI interests. Royalty is a gross revenue interest reserved by the landowner. The overriding royalty (“ORRI”) is similar to the landowners royalty, but derives from the oil and gas lease. The ORRIs are valued in terms of the acreage and wildcat well drilling costs because these are the company's investments at risk. The company considers the risks and rewards of the working interest acceptable and competitive within the industry. The ORRI valuation is based upon the drilling company's valuation. In addition, the ORRI pays no investment or operating expenses and is usually valued at about twice the working interest per share of revenue interest.
One example of equity financing for natural resource exploitation is a high-risk loan compensated by both a nominal interest rate and an assignment of a small ORRI. However, the ORRI is subject to the same variance as the underlying assets, the transaction is taxable, the ORRI is not liquid, and the transaction only involves two parties.
Royalty financing of natural resource exploitation has been used for a long time. Investors buy a royalty interest from a company. The company uses the money for whatever its needs might be. Royalty financing is a sale of royalty unless there is a stipulation that the company gets the royalty back when the royalty buyer realizes a specified return from the royalty income. Royalty financing does not reduce risk. Royalty financing does not offer an improved price over industry standards. Royalty financing does not improve liquidity. Moreover, in royalty financing, the transaction is taxable, and the transaction only involves two parties. When the transaction between the two parties, the company and the financial community, is limited to one market, the risk can only be shared between the two parties.
The financial community was the first to realize that the same assets had different values in different markets. This concept contrasts with the efficient market theory of modern economics. The late Fisher Black who moved from Massachusetts Institute of Technology to Wall Street commented, “Markets look a lot less efficient from the banks of the Hudson than from the banks of the Charles.” This difference in market values is a foundational principal behind arbitrage. Arbitrage is the practice of taking advantage of a price differential between two or more markets. Arbitrage matches buyers and sellers in different markets, striking deals that capitalize upon the imbalance, the profit being the difference between the market prices.
Tax consequences are another important consideration when valuing and exchanging assets, particularly for exchanges between markets with arbitrage. Under IRS rulings, real estate and petroleum properties are of like kind. IRS Section 1031 gives someone who sold real estate six months to invest in a like kind investment. Consequently, an IRS Section 1031 market for royalties and overrides has developed. A higher price could be realized for royalties in this market because the buyers are primarily interested in preserving their capital and avoiding taxes. The IRS Section 1031 market is a true exchange market that does not reduce risk.
Petroleum Strategies, Inc. in Midland, Tex., was founded in 1991 to assist in structuring the sale of oil and gas properties to qualify for tax savings under IRS Section 1031 regulations. The company has facilitated over $6 billion in exchange transactions, providing service to major oil companies, independent operators, and individuals.
Noble Royalties in Dallas, Tex. began selling producing minerals and royalties in approximately 1995, and in 2005 began selling assets into the IRS Section 1031 market to realize improved value by arbitrage.
The IRS Section 1031 market created the first arbitrage between markets for petroleum assets. Industry experts estimate that in 2007 50% of all mineral or royalty asset sales for cash were IRS Section 1031 transactions. Therefore, a need exists for a way to extend the benefits of asset exchange and arbitrage to markets other than the IRS Section 1031 market.
A new business structure specifically designed to work with different markets is the Master Limited Partnership (MLP). The MLP is a publicly traded limited partnership composed of underlying, non-liquid assets. However, if asset exchange between a company and an MLP is to be tax free, the assets must be of “like kind” with no unrelated business income taxes (“UBITs”). A UBIT may also be referred to by persons skilled in the art as an unrelated business taxable income or UBTI. As used herein, “UBIT” and “UBTI” shall have the same meaning. Real Estate and oil and gas interests are “like kind”, but only oil and gas mineral and royalty interests generate revenue with no UBITs. MLP as used herein shall refer to a MLP with assets of producing royalty and mineral interests that does not generate UBITs. Tax free exchanges can be made with an MLP. An MLP qualifies if the MLP is publicly traded and has assets that do not generate UBITs. A qualifying MLP is a potential source for Units to be exchanged for royalty interests. Each unit of a MLP represents a fractional interest in the assets of the MLP. Under Internal Revenue Code Section 721 assets can be exchanged for tax free units. Specifically, Internal Revenue Code Section 721 states “[n]o gain or loss shall be recognized to a partnership or any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.
MLP Units are traded daily on the stock exchange providing liquidity. The mineral and royalty based MLP Units have the ability to attract large sums of capital if the yield on the MLP Units exceeds the short-term bond yield by a few percent. Producing mineral and royalty interests are acquired by an MLP and the revenues are distributed monthly to holders of MLP Units. Asset exchanges with the MLP for MLP Units are frequently referred to as tax-free, but are actually tax-deferred. Tax-free asset exchange eliminates costs associated with transforming risk, accessing new markets, or accessing new capital sources. Asset exchange simplifies transactions because all assets have identical future pricing. In the asset exchange, both buyers and sellers apply their respective future pricing scenarios to both assets in arriving at present day values. The resulting asset exchange is based upon relative values, which are independent of future prices for all transaction parties. Furthermore, asset exchange converts oil and gas interests into MLP Units that are not subject to the same regulations and financial constraints creating an opportunity for arbitrage. The opportunity for arbitrage enables financing to be based upon a larger percentage of the underlying asset value.
An example of an MLP is the Sabine Royalty Trust (Sabine), which has been listed on the New York Stock Exchange under the stock symbol, SBR for some 20 years. Sabine is composed of only producing mineral and royalty interests. Sabine is prevented from buying or acquiring properties by its prospectus and is a declining asset. However, over the history of Sabine, unit price and annual dividends have been linearly related. The stock market values Sabine as a perpetuity rather than a declining asset illustrating the presence of multiple market values for the mineral and royalty assets.
A need exists for a method to capitalize on the properties of the MLP to enable or enhance energy financing. In traditional financing transactions for the exploration, development, and exploitation of natural resources, valuation of assets is limited to one market, such that risk reduction through asset exchange and arbitrage are not possible. Therefore, a further need exists for a way to facilitate the movement of assets between markets so that risks can be reduced and asset values can be maximized. Furthermore, a need exists for a way to restructure the underlying assets to enable otherwise marginal financial transactions to take place.